10.2 Hedge Funds, Strategies, Fees, and Risks
Key Takeaways
- Hedge funds are pooled vehicles that often use leverage, short selling, derivatives, concentrated positions, and flexible mandates.
- Major strategy families include equity hedge, event driven, relative value, global macro, managed futures, and multi-strategy funds.
- Management fees compensate asset gathering, while incentive fees reward performance and may be constrained by hurdle rates and high-water marks.
- Key risks include leverage, short squeeze risk, liquidity mismatch, model risk, counterparty risk, crowded trades, and operational failure.
- Exam questions often distinguish absolute-return objectives from true market neutrality.
Hedge fund purpose and structure
A hedge fund is a pooled investment vehicle that gives the manager broad discretion to pursue a stated strategy. Many hedge funds are offered privately to qualified investors and are not regulated like ordinary retail funds. The manager may use short selling, leverage, derivatives, concentrated positions, and less liquid securities.
The term hedge fund does not mean the portfolio is fully hedged. Some funds try to reduce market exposure. Others take directional views on currencies, rates, credit, commodities, or corporate events. The common feature is flexible active management, not a guarantee of lower risk.
Strategy families
| Strategy | Return source | Common risk |
|---|---|---|
| Equity long-short | Long undervalued stocks and short overvalued stocks | Equity beta and short risk |
| Equity market neutral | Offset long and short equity exposures | Model and execution risk |
| Event driven | Merger, restructuring, spin-off, or distressed events | Deal failure and liquidity risk |
| Strategy | Return source | Common risk |
|---|---|---|
| Relative value | Pricing differences between related securities | Leverage and convergence risk |
| Global macro | Views on rates, currencies, equities, and commodities | Large directional loss |
| Managed futures | Trend following across futures markets | Whipsaw and crowding risk |
Equity long-short managers buy securities they expect to outperform and short securities they expect to underperform. Net exposure can be positive, near zero, or negative. A market-neutral fund tries to reduce systematic equity exposure, but it can still lose money from poor security selection, factor shocks, leverage, or short squeezes.
Event-driven funds invest around corporate actions. Merger arbitrage usually buys the target and may short the acquirer. Distressed strategies buy debt or equity of troubled issuers and may depend on legal outcomes. These strategies can look stable until a deal breaks or credit liquidity disappears.
Relative value strategies seek small pricing differences, often with leverage. A small spread can become a large loss if the relationship widens before it converges. Global macro funds make top-down bets using currencies, rates, equity indexes, commodities, and derivatives. Managed futures funds often follow price trends with futures contracts.
Fees and investor terms
Hedge fund fees often include a management fee based on assets and an incentive fee based on profits. The common phrase 2 and 20 means a 2 percent management fee and 20 percent incentive fee, although actual terms vary. Fees reduce investor returns and can make manager selection critical.
A hurdle rate requires the fund to earn a minimum return before incentive fees apply. A high-water mark prevents the manager from earning incentive fees on gains that merely recover prior losses. Without a high-water mark, investors could pay performance fees after a rebound that still leaves them below a prior peak.
Liquidity terms matter as much as fees. A fund may require a lock-up period before redemption, advance notice for withdrawals, and redemption windows such as monthly or quarterly. Gates may limit withdrawals during stress. Side pockets may separate hard-to-value or illiquid assets from the main fund.
Risk controls and due diligence
Hedge fund analysis should separate gross exposure, net exposure, leverage, concentration, liquidity, counterparty exposure, and operational controls. Gross exposure measures total long plus short exposure. Net exposure measures long exposure minus short exposure. A fund can have low net exposure but high gross exposure and large leverage.
Operational due diligence reviews service providers, custody, valuation policies, trade reconciliation, compliance, cybersecurity, key person risk, and auditor quality. Many hedge fund failures are not caused by a bad macro view alone. They can involve weak controls, fraud, valuation manipulation, or hidden leverage.
Structured aid: hedge fund exam filter
- Identify the strategy family before judging risk.
- Distinguish long-short from market neutral.
- Check whether low net exposure hides high gross exposure.
- Apply fees after gross performance, not before.
- Link liquidity terms to underlying asset liquidity.
- Treat high-water marks and hurdles as investor protections, not return guarantees.
Exam traps
Absolute return does not mean always positive. Market neutral does not mean risk free. Leverage can magnify both good and bad trades. Short positions can lose more than the original short-sale proceeds. A high-water mark protects against repeated incentive fees on recovered losses, but it does not prevent losses.
The most defensible answer usually recognizes both opportunity and constraint. Hedge funds may improve diversification and access manager skill, but the investor must underwrite liquidity, fee, operational, valuation, and strategy risk.
A hedge fund has long equity exposure of 130 percent of capital and short exposure of 70 percent. The fund's gross exposure is closest to:
A high-water mark in a hedge fund fee arrangement most likely:
Which statement about hedge funds is most accurate?